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Monday, 7 May 2012

A Wake- Up Call....

A Brief commentary on Indian Economy

The recent degradation of India’s fiscal outlook from “stable” to “negative” by S&P created brouhaha in India’s economic, political and intellectual circles. The critics were quick to point out that the rating agency’s outlook on India is unsolicited, given the fact that Indian government does not raise money from foreign markets. True, but can’t we take it as a wakeup call?

Let’s look at S&P’s action objectively, was it really a surprise? Was it justified? The answers, which many would not appreciate, are No it’s not a surprise and yes it’s justified to a certain extent.

The government was faced with Janus-faced objective of enhancing economic growth and containing inflation. Year 2011-12 was a tough one for the Indian economy. The GDP grew at its slowest annual pace in three years between October to December 2011. At the year-end GDP growth was 6.9%, much lower than the 9% growth projections announced only a year ago. High inflation and rising input costs restricted investments and slowed manufacturing.

Another major cause of concern is India’s fiscal situation. In the last budget the government announced that it would lower the fiscal deficit to 4.6% of GDP for year 2011-12. This target could not be met due to a plethora of reasons. Uncertainty in global markets and European debt crises created sustained pressures on the Indian economy. High import bill due to rising Oil imports, large fertiliser subsidies and rising import prices of Gold imports took a toll over the fiscal balance.

Low tax revenues and heavy loss to exchequer due to subsidies prompted the government to look for alternative ways to finance the fiscal deficit, thus the government resorted to disinvestment. It expected to raise Rs.40,000 crores from disinvestment proceeds but could raise a meagre Rs. 1,145 crores through this alternative channel. Thus the year ended with sneering fiscal deficit of 5.9%, a far cry from the target of 4.6%.

On the monetary policy front, Reserve Bank of India (RBI) struggled throughout the year to contain high inflation by raising interest rates, but this policy instrument brought about only moderate corrections in inflation much less than expected. Despite decline in domestic demand, inflation on Wholesale Price index (WPI) remained high due to price stickiness and continued depreciation of rupee. High interest rates lead to higher cost of borrowing, which in turn lead to high input costs, thereby reducing the profit margins and slowing down the manufacturing sector. Consequently, the industrial growth plummeted to its lowest levels in five years, and the Index of Industrial Production (IIP) declined and often went negative.

RBI has shown its concerns over the rising Current Account Deficit (CAD), which reached its highest levels since the balance of payments crises of 1991. The current account deficit reached 4.3 per cent of GDP in Q3 of 2011-12. The widening to CAD to uncontrollable levels can impair financial stability of the economy. RBI as also emphasised that debt inflows will not solve this issue since such funding will have implications for India’s external debt position and, consequently, for financial stability. Also, India’s external debt increased to $334.9 billion (December 2011) or 20% of GDP, second highest in the continent after Japan.

The tax reform announced in the budget further deteriorated investor sentiments. With the provisions of General Anti-Avoidance Rules and retrospective tax law changes, there is a feeling of uncertainty and high compliance burden that has aggravated the situation. Such sentiments may impair foreign direct investment (FDI) that has turned negative over the past two years.

High fiscal deficit, High inflation and rising Current Account Deficit (CAD) are the unholy trinity which paint a dismal picture of India’s economy and threaten economic growth. India urgently needs bold reforms. Tough decisions on fuel and fertilizer subsidies like deregulation and rationalization, increasing export competiveness and strengthening supply chain to address the supply side dynamics of inflation are needed to contain high fiscal deficit, rising CAD and soaring inflation.

The good news in this grim economic situation is that India’s rating remains unchanged. At many levels, S&P’s cutting of India’s outlook from “stable” to “negative” was required to bring us out of our slumbers. It’s high time that we take this as a wakeup call.